Urban Vibrancy and Firm Value Creation

Financial economists have long been interested in the reasons some organizations create more value than others. One common measure takes the difference between a firm’s market value and the replacement cost of its assets, under the notion that when management adds little value, the firm should be worth approximately the value of its plants, equipment, and other physical assets. On the other hand, when managers can squeeze more value out of these assets, the “market-to-book” ratio can substantially exceed one, the wedge representing value created for its shareholders. In this paper, we ask whether the location of a firm’s headquarters represents a source of comparative advantage, and accordingly, whether market-to-book ratios differ meaningfully between headquarter cities.

While it might seem obvious that some cities are more productive than others—and they are—this does not necessarily imply higher stock prices for resident firms. One reason is that more productive workers will command higher wages, and if land is scarce, real estate prices will climb, both putting downward pressure on firm profits. Another factor is competition. Even if a firm’s shareholders initially benefit from a superior location (i.e., net of higher wages and land prices), entry from competitors may limit the upside over long horizons, the latter of which is most important for stock prices. Indeed, most traditional urban economics models assume that productivity differences due to local factors are competed away by firms, leaving little residual benefit for shareholders.

With this background in mind, we measure market-to-book ratios between firms headquartered in the largest 38 U.S. cities. The headline result is that shareholder value creation is increasingly concentrated in a relatively small number of metropolitan areas. While Silicon Valley is clearly part of the story, it is certainly not unique, with other cities such as Boston, Seattle, Minneapolis, and Washington D.C being associated with large increases in market-to-book ratios. One relevant observation is that these tend to be tech-heavy cities, but even when we account for industry-level differences, the same patterns emerge.

Rather, what seems more crucial is a city’s ability—or inability—to attract or cultivate high-skill workers, or what Florida (2002) and Moretti (2012) have termed the creative class. For example, college education rates (measured prior to the start of our sample period), a powerful indicator of a city’s appeal to high-skill workers, is a strong determinant of resident firms’ abilities to create shareholder value. Education rates operate at both ends of the distribution, simultaneously explaining why firms in the most literate cities like Washington D.C. and Boston have done so well, while those in comparatively less educated ones like Charlotte and Providence have lagged behind.

We also find that firms headquartered in cities with harsh weather, particularly hot and/or humid summers, have underperformed their counterparts in more pleasant climates. Because prior research has shown that population growth is strongly related to weather, our initial interpretation was that population growth is good news for local firms, perhaps due to access to abundant, cheap labor. However, on closer inspection, this interpretation does not appear correct, as none of the fastest growing 10 cities since 1985—booming areas with cheap housing such as Phoenix, Atlanta, Dallas, Houston, and Charlotte—have experienced significantly positive changes in Tobin’s q, and most are negative. Rather, the impact of weather is particularly pronounced at the extremes, with value creation being increasingly concentrated in mild-weather cities on the West Coast, a phenomenon clearly not attributable to cheap labor and/or real estate.

The implication, of course, is that productivity advantages in cities with high Tobin’s q must (more than) offset the cost of higher local inputs. However, how a firm’s performance is measured ends up being critically important. If we measure performance with flow variables such as accounting profits, a curious result obtains: cities with the highest firm values have markedly lower return-on-assets, and other profit measures. In other words, measured in the short run, land owners and workers appear to be capturing virtually all the local productivity benefits. It is only when we examine stock variables that capture a firm’s future profitability—i.e., its growth opportunities—that a positive relation with Tobin’s q reemerges.

Our analysis of stock returns provides further evidence that the growing importance of location corresponded to the emergence of the information revolution. Indeed, firms headquartered in the cities with highest Tobin’s q realized higher returns throughout our forty-year sample period. However, most of the superior returns were realized in the latter half of the 1990s.

Overall, our evidence suggests that shareholders of public companies have been significantly affected by the internet/technical revolution, liberalized trade, and reduced shipping costs, all of which made it possible for management and production to be geographically, but not functionally, separated. Whereas manufacturing and assembly have steadily been relocated to cheaper locations, a relatively small number of cities appears to be responsible for product design, engineering, and other high value-added activities. Crucially, there appear significant incumbency advantages with respect to reaping these locational benefits, since although areas like the Bay Area, Seattle, and Boston spawn new firms at higher rates than other cities, new entry does not appear to have completely eliminated the benefits for resident firms’ shareholders. A better understanding of what factors limit local competition/entry is, in our view, a fruitful topic of future research.

The complete paper is available for download here.